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GameStop: Short-selling explained

Clarity Wealth Management

If you have been anywhere near the news over the last few weeks than you may have come across the story on the US company GameStop. There is currently a war waging on Wall Street between wealthy hedge fund managers and retail investors. It is reminiscent of a modern-day Robin Hood story, and the irony is that the Robinhood trading app is very much involved, unwillingly in this war.  If you have been following this story with an eagle eye, then you may have come across the phrase ‘short selling’ and wondering what all this means. This article will attempt to give you a further understanding of what short selling is and how GameStop has been embroiled in controversy over the last few weeks.

What Is Short Selling

Short selling does not have the best reputation; it is viewed as unethical by many people as it essentially allows Investors to make profits out of failing companies. If you have seen the film The Big Short, you will understand why some people deem it unethical and borderline illegal. The movie illustrates how a group of hedge fund managers shorted market-based mortgage-backed securities. When the sub-prime mortgage market imploded in 2008, the hedge fund managers made vast amounts of money, one just short of $500 million. Many people viewed this as unethical as many ordinary people suffered and lost their homes.

Short selling allows investors to profit from stocks or other securities when they fall in value. In order to short sell, an investor borrows the stock or security through a brokerage company or pension fund, the investor then sells the share in the stock market. Over time the short seller hopes the price will fall, the further the better. This provides the opportunity for the short seller to buy back the stock at a lower price than the original sale price allowing him to retain any money left over after the brokerage fee.

How Does This Work

A short seller thinks the share price for 123 company will go down in value over time and decides to take a punt at it.  The short seller borrows one share of 123 Company from a broker for a fee; they then sell the share in the market for £100. The share price goes down to £50 overtime in which the short seller exercises his right to buy back the share at £50. They then sell it back to the broker for £100 and keep the £50 profit minus the broker's commission.

Although on paper, this may seem like a straightforward strategy and a quick way to make a profit, it actually entails major pitfalls which is why it is usually only for experienced investors. When you buy a share the traditional way your potential losses are capped at 100%, for example, you buy a share for £100 in company 123; if the company goes under then, you lose £100. When shorting a share, the maximum gain is only 100% of the original investment, but the potential losses are infinite. Say you short a stock in company 123 and borrow it for £100, but in this scenario, the stock does not go down in value but explodes in the opposite direction and rises to £500. The short seller in then in a position where he has pay the broker £500 for the share he borrowed on top of any borrowing costs. The short-sellers are also responsible for paying out any dividends from the borrowed share during the period they hold it, which further squeezes profit margins. 

Game Stop

So what is happening with Game Stop I hear you ask... Well, this is a prime example of how shorting a stock can be devastating for the short seller. A group on Reddit known as WallStreetBets captured the world's imagination after they went to battle with some of Wall Streets Billionaire hedgefund companies who had betted on the share price to go down. When WallStreetBets caught wind of this, they took up arms by piling money into Game Stop to up the share price, resulting in short-sellers losing billions of pounds. To put the losses into perspective if the short seller bought shares at the beginning of the year around the $20 mark, they would have had to sell the share back to the broker for $350 at the end of January. This was why big hedgefund companies such as Melvin Capital lost significant sums of money in the Game Stop war.

The modern-day David vs Goliath story has brought both commendation and praise from various high profile politicians, finance managers and wealthy investors. The frenzy was assisted by trading platforms and apps such as Robinhood who themselves have found themselves stuck between a rock and a hard place as they have tried to appease both small investors and Wall Street. Robinhood trading app was forced to restrict trading in these shares to meet the demands in their operations; this has resulted in a massive backlash from their app users. Robinhood has always pitched themselves on the small investors' side, allowing small investors to do similar transactions to what large financial institutions do.

What does this mean for us on the other side of the pond? There is an old saying, ‘if a butterfly flaps it wings it can cause a tornado on the other side of the world., This has the potential to catch on over here. The FCA announced last week that they would be closely monitoring the situation in case the flames start to ignite in the City of London. Although I admire the little guys standing up to Wall Street's big bad bosses, it will inevitably end up in disaster as the rise in share prices in failing firms is simply unsustainable. As I am writing this, Game Stop's share price has plunged 58% by the end of trading today. Also, it is likely your pension will be holding shorted stocks so the fall-out could have more far-reaching consequences.

With retail investors now moving on to other targets such as commodities and other failing companies, the end of this war is hard to predict. However, it will be interesting to see politicians and regulators' reactions in the coming weeks, until then, I guess we need to sit tight and watch the show.

Nicholas Morris Dip FA
Clarity Wealth Management